Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm's fixed capital budget of $10,000,000. Any unused portion of this budget will earn less than its 20 percent cost of capital. A summary of key data about the proposed projects follows.
PV of Inflows
- Use the NPV approach to select the best group of projects. (Note that just the PV of inflows is given, you must subtract the initial investment to find the NPV.)
- Use the IRR approach to select the best group of projects. (Note that the discount rate or the cost of capital is 20%.)
- Which projects should the firm implement based on your analysis of both techniques and given the capital rationing amount? Write an email to your boss, Andy Fast, the CFO, explaining your rationale proving the choices based on the considerations of shareholder value and the maximum investment budget. Keep in mind that you are less concerned with using the whole budget than with maximizing the total return to Galaxy satellite.
Explanation & Answer
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Running Head: CAPITAL BUDGETING
Net Present Value formulae, in case of a project spanning over multiple years, is given
NPV= CF0 + CF1/(1+K)1 + CF2/(1+K)2 + CF3/(1+K)3 + CF4/(1+K)4 +… + CFn/ (1+K)n
CF = Cash flow
K = Rate
n = Number of years (Brealey, Myers & Sandri, 2011).
NPV is also calculated using the formula;
NPV = PV of future cash flows - Initial Investment
Source: Brealey, Myers & Sandri (2011)
Using the formulae above to calculate the NPV for the various projects yields the
NPV = $(3, 050, 000-3, 000, 0000) = $50, 000
Maximum earning from the unused...